Tuesday, June 14, 2005

The Real Estate Bubble: A Capsule Summary

Here it is in a nice quick-to-read nutshell.

Recently, a friend of mine was offered a job in Southern California. The job was interesting, the place was beautiful and the pay was excellent. Or at least it seemed excellent until he learned about house prices. A house that would cost about $200,000 in Indy was going for $1 million or more out there. He said no, but was urged to reconsider by a would-be colleague who told him that he could expect his home to grow in value by 20 percent per year. Buying that million-dollar home would, she maintained, be "the best financial decision you have ever made."

There is, as this story suggests, a housing bubble in America. Not everywhere. Probably not here in Indy. But there is one in California for sure, and by most estimates in parts of at least 22 other states. Many people are investing in real estate in the hope of making a lot of money really fast, borrowing heavily in the belief that the price of real estate will never go down.

But that belief is simply wrong. Yes, prices are rising in many places by 20 percent or more per year, but at some point, probably soon, the market will peak and many investors will lose heavily. And if there is a collapse of housing prices, there could be dire consequences for the U.S. economy.

Of course, many homebuyers are not investing in real estate to make a killing; they are only trying to fulfill the American dream of home ownership. But even these homebuyers assume that it's a good investment and that it's surely better to buy than to rent.

But right now, in a lot of places in the U.S., it isn't a better idea. On both coasts, in parts of the West and Southwest especially, it is cheaper -- often much cheaper -- to rent a home than to buy one, even with all the tax deductions thrown in.

20% a year, eh? A sure thing. That means that in 10 years that $1 million house will be $6 million. Mortgage and property taxes alone would then consume $30,000 a month. Lessee, to carry that you'd need to be grossing on the ol' W2 about $60,000 a month, which is $720,000 a year. And all that for a house that has an "Indianapolis equivalent worth" of $200,000. No problemo, as long as your raise is 26% a year every year for that decade, which is a reasonable assumption if a Big Mac is going to cost $25 in 10 years. So, I say, go for it.

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